Friday, May 30, 2008

Energy, the FED, and Inflation

"For years, Washington has failed to address the issue of rising energy costs and, as a result, the country now faces a true energy crisis, one that is causing serious harm to America's manufacturing sector and all consumers of energy. The government's failure to develop a comprehensive energy policy is causing U.S. industry to lose ground when it comes to global competitiveness, and our own domestic markets are now starting to see demand destruction throughout the U.S." – Dow Chemical CEO
I have to say this energy debate is really providing me with some great material. I also think this debate is revealing a lot about how out of touch with reality some of America’s politicians and business leaders have become. I have but one simple question: What is an Energy Policy in a Free Market? I don’t get it. Either you have it or you don’t. Alternative forms will act as substitutes at competitive prices or demand will eventually come off as the price increases. What policy is needed other than physically confiscating it from those nations that possess the resource in mass quantities? If the government forces people to drive less, carpool, relocate to urban areas, or any one of several things they can do to encourage conservation, there will be other economic consequences. Stores like Wal-Mart, Target, and Best Buy will suffer as human traffic declines. The broad services industry will take a big hit, and of course, the housing industry and financial services sector would go through some major adjustments (which is in fact what is already happening). So, while we save on oil, we lose in other areas as economic activity slows down. This is a natural rebalancing.

What people want is for economic activity to continue at the pace it was going over the last few years and for energy prices to fall. Hmm….if you know nothing about economics I can understand where you are coming from…but if you are senator Schumer…Donald trump…or the CEO of a major corporation…you do not have an excuse. Trade is about goods and services. It is pretty fricking simple. If what you have to offer in exchange for food and oil is financial paper…well then you had better make sure that paper is some high quality stuff. While the commodity boom is a great wealth transfer story, it is also a story about credibility.
Make no mistake one of the major drivers behind this commodity mania is that investors are storing value in them. So, while the financial prognosticators are focusing on how the U.S. markets are holding up, you should be focusing on the fact that many people are losing faith in certain financial assets. If you have figured out there is a lot of toxic waste out there and that regulators are utterly incompetent, well then… you simply are boycotting the system and moving your money into something more reliable. Why is this happening? Take a look at what’s going on with Fed’s balance sheet.

As you can see(the chart i built is based on aggregate assets of the FED as of May 23,2008) it’s changed quite a bit over the last 12 months. In fact, they had to literally change their subcategories, as the line item “loans to depository institutions” isn’t adequate to cover their lending operations anymore. They now use the classification “other loans” so they can account for their new Primary Dealer Credit Facility. Clearly the Fed has decided to bear the burden of risk within our financial system and bail out the banks and the mortgage backed security market. The upside to all of this is that their actions are providing a stopgap for the struggling real estate market and buying banks badly needed time to recapitalize. The downside is that it is at the expense of the dollar and long-term price stability. The fed does not have a magic wand. They cannot make the toxic waste in the system disappear. So, to the extent that they try to do this, and so far they have employed multiple strategies (TAF, TSLF, PDCF....more and more acronyms….but the same problems) they will ultimately fail. The Market Ticker Blog pointed out a great quote from Alan Greenspan that he made many years ago regarding FDIC insurance “We can guarantee you that you will receive your dollars, but not what they will be able to purchase.”
Honestly, this quote hits right to the heart of the problem. By trying to bail out banks and brokers and buy time for homeowners who made very bad decisions the Federal Reserve is creating another problem…inflation. Which problem is more serious? Well inflation directly affects every single person and corporation in the United States. It makes their lives and businesses more difficult to manage. The credit crunch on the other hand is bad for businesses and people that depend on debt and the use of levg to make money, and for the most part, if it had been left to work itself out would have done the majority of its damage outside of Main Street. The big losers would have been the stock market which would be lower…and the financial services industry….which would have had to shed jobs at a faster pace. These two things will eventually happen …albeit in a more orderly manner. Sadly, before the fed can celebrate saving Wall Street they will be stuck trying to figure out how to save everyone from inflation. Moreover, as we have seen great dissention at the Fed of late…it appears that a few members and plenty of ex members realize that this could be a difficult battle. What do we as Americans have to look forward to?
1) Higher long-term rates
2) Higher taxes
Two things I tend to associate more with long-term bear markets for equities than long-term bull markets.

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